Choosing a Legal Structure

Often, the first business decision you'll make can be the most difficult of all.

One of the first startup decisions you'll make for your new business is deciding what type of business organization is best for you. There are four main choices in organizing your business. Listed from the simplest to the more sophisticated they are:

The sole proprietorship The partnership The corporation The limited liability company

Sole proprietorship

A sole proprietorship is a business with one owner. Of the four types of organization it is the most common. A business organized as a sole proprietorship is not separate from its owner, but merely a different name with which the owner represents him/herself to the public. The owner is the business and the business is the owner. They're inseparable.

Because of this relationship, a sole proprietorship is known as a pass-through entity. This means that all income and expenses pass-through to, and are filed as, part of the owner's personal tax return. If there is a business loss, the owner will enjoy a deduction to offset personal (paycheck) income. However, if the business makes a profit, the owner is responsible for any taxes due.

Since they have few legal requirements, sole proprietorships are easy to form and operate. They can also be more affordable since no legal documents need to be filed in most cases. Basically, all one has to do to form a sole proprietorship is file an "assumed name" form at the county clerk, get a business license (if required) and begin operations.

Although the sole proprietorship does have the advantage of simplicity, the negatives can steer entrepreneurs away from this form of business organization. The disadvantages of a sole proprietorship stem from its very nature - the business and the business owner are inseparable. This leads to three potential problems.

First, owners can lose some lucrative tax-free fringe benefits because they cannot participate in company-funded employee benefit plans like medical insurance and retirement plans. Second, since the owner and the business are inseparable, whoever sues the business actually sues the owner. The owner's personal exposure is unlimited. Finally, the business owner is personally liable for the debts of the company, and unfortunately, personal assets can be taken to pay company obligations.

Partnership

A partnership is similar to a sole proprietorship but has two or more owners. Like the sole proprietorship, the partnership is not a separate legal entity from its owners. Unlike the proprietorship, however, the partnership can hold property and incur debt in its name.

In general, the partnership shares the same advantages and disadvantages as the sole proprietorship (see above). However, the partnership has an additional drawback. A partner can be held liable for the acts of the other partners, increasing personal liability.

Tax treatment of the partnership is also slightly different. Although it is a pass-through entity and does not pay its own income tax, the partnership does file an informational tax return with the IRS. The pro-rata share of its income and expenses are shown on each partner's personal return, and any taxes due are paid by the partners. Of course, the business will make quarterly estimated tax deposits to avoid a large year-end tax obligation.

Corporation

The corporation was conceived to solve the typical problems of the proprietorship and partnership. Incorporating allows one person or a group of entrepreneurs to act as one, much the way a partnership does, with one important advantage. Since the corporation is a separate legal entity capable of being sued, it can protect its owners by absorbing the liability if something goes wrong.

A corporation is essentially an "artificial person" created and operated with the permission of the state where it is incorporated. It's a person like you, but only "on paper." A corporation is brought to life when a person, files a form with the Secretary of State known as the "Articles of Incorporation". The owner of a corporation is known as a shareholder.

Since a corporation is a separate legal entity, the corporation actually owns and operates the business on behalf of the shareholders, under the shareholder's total control. This separation provides a legal distinction between the owner and the business and provides three important benefits:

It allows you, the owner, to hire yourself as an employee (typically as president) and then participate in company-funded employee benefit plans like medical insurance and retirement plans. Since you and your company are now two separate legal entities, lawsuits can be brought against your company instead of you personally. When debt is incurred in the company name, you are not personally liable and your assets cannot be taken to settle company obligations.

S Corporations

An "S" corporation is the same as any other business corporation with one important advantage - the IRS allows it to be taxed like a proprietorship or partnership, a pass-through entity. In other words, you pay tax at personal income tax rates- not corporate tax rates, usually resulting in less taxes owed.

When business corporations are created, they are all regular "C" corporations. To become a Subchapter S, you file IRS Form 2553. It is important to remember that being an S corporation is a tax matter only. One restriction of S Corporations is that they can have no more than 75 shareholders (owners), but can have an unlimited number of employees and annual sales.

Limited Liability Companies

A limited liability company is the newest form of business organization. Available in 49 states, it's a hybrid entity that combines favorable aspects of the corporation and partnership. The LLC features pass-through taxation similar to a partnership, and limited liability like a corporation. You may choose to see it like this - the LLC is a partnership that offers the limited liability protection of a corporation. Or conversely, it's a corporation that's taxed like a partnership. Yes, it is much like an S corporation without the 75 shareholder limitation.

The limited liability company is a promising type of business entity, but it does have a couple of disadvantages. First, its newness means that law regarding the LLC is still evolving and some issues regarding its operation remain unsettled. Also, if the LLC is taxed as a partnership, business owners will lose some company-funded benefits. Those trying to choose between Subchapter S and LLC should seek advice from their attorney and CPA.